Fed without fear of inflation should scare investors

Last week, Fed Chairman Jerome Powell outlined the final two steps: looking at where inflation really is, rather than worrying about what it should be, and clarifying that neither excess current wild stock market nor the recent surge in bond yields bothers him.

This change should lead to a reassessment of the dominant market discourse. So far, the assumption has been that the Fed will tolerate some short-term inflation created by President Joe Biden’s $ 1.9 trillion stimulus, but in the long term the Fed will reassert control or inflation will go away on its own.

In the bond market, this version of the story manifests itself in heightened inflation expectations for the next five years – a breakeven point of 2.51%, although on a measure generally higher than the preferred measure of inflation. from the Fed. For the next five years, inflation expectations are much lower, at just 2.11% on Friday; if that’s true, that would almost certainly mean the Fed’s preferred inflation measure would be below its 2% target.

An alternative narrative is much more political and is gaining popularity with investors looking at economic history. It starts with transforming the deficit debate. After Obama’s 2009 relaunch, even Democrats worried about how it would pay off, and the popular parallel was with struggling states like Greece.

This time around, the concern of mainstream Democrats, as it is, is that overspending could cause inflation.

Of course, Republicans in Congress have rediscovered fiscal probity since the loss of the White House, and the majority of Democrats couldn’t be more fragile. But over the past decade, virtually everyone has come to understand the basic tenet of modern monetary theory – that the issuer of dollars will not go bankrupt.

Here, the story goes to the Fed. A hawkish Fed can thwart a White House that spends heavily by raising rates. But Mr Powell pledged not to increase until inflation reaches the Fed’s sustainable target and the country is at full employment. Most policymakers think this means at least three more years of near zero rates.

The question is what happens if the goal is reached sooner. If inflation rises quickly, say to 3%, will the Fed be willing to raise rates early and risk rising unemployment? And 4%?

Fed policymakers have insisted that achieving full employment helps marginalized people in society the most. The flip side is that pushing up unemployment to limit inflation will hit this group the hardest. Politically, this makes a stricter monetary policy to justify.

There are also broader issues pushing for higher inflation, as Pascal Blanqué, chief investment officer at French fund manager Amundi Asset Management, points out. Growing national rivalry, along with restrictions on the export of protective gear and vaccines, are encouraging companies and governments to secure domestic supply chains, even if it comes at higher costs.

A synchronized global recovery this year will put upward pressure on commodity prices, a classic source of inflation. And the Covid-related disruption has led to widespread production issues, including shortages of shipping containers and critical parts for cars, which again points to higher prices.

“There is a continuous shift from the narrative from secular stagnation to what I call the road back to the 1970s,” Blanqué says.

I think it’s safe to leave the flower bells in the closet. Severe inflation is still highly unlikely, although it is now more likely than it used to be. The labor market is much more flexible than in the 1970s, making wage-price spirals difficult, while international competition is still abundant to restrict the ability of firms to raise prices. These trends could be reversed, but it will take years for unions to strengthen their power and economies to shift towards national production.

However, everything is in place for at least one episode of market anxiety in the face of inflation.

Inflation is set to climb over the next few months due to a sharp drop in prices a year ago, as Mr Powell himself pointed out on Wednesday. He said the Fed would ignore what he expected to be simply failure. The economy is also likely to grow rapidly; the New York Fed’s Nowcast model, for example, forecasts annualized growth of 6.3% in the first quarter.

Combine that with a commitment to low rates and a president already moving on to his next spending plan, and it makes sense for people to worry more about rising prices.

“Investors are ready for a fear of inflation,” says Dario Perkins, economist with TS Lombard strategists, although he thinks it is unlikely to last.

The obvious bets to profit from a fear of inflation are the reverse of what worked last year: dump treasury bills, dump high-quality bonds, dump growth stocks, buy cyclical stocks economically sensitive at low prices, buy commodities, buy rotten bonds.

The market as a whole could rise or fall, depending on its constituents, as last Thursday showed: The S&P 500 was dragged down by sharp declines in growth stocks, even as its cheap and cyclical members have suffered less and that the banks grew. In Europe, the same pattern led to the market rising, with cheap and cyclical stocks making up a larger share.

Much of this has already happened, as the same trades are benefiting from the economic reopening. The fear will therefore have to be great to overcome what is already provided for in the price.

Yet a steady state change is clearly not counted in the treasuries. Even after last week’s jump, the 10-year still only returns around 1.7%, and long-term bond market inflation expectations have remained stable. Investors, by and large, accept Mr Powell’s speech and believe that after a brief period of price hikes, the Fed will be ready to assert its independence and keep inflation in line.

If the market loses confidence, yields on long-term Treasuries would rise even faster, the dollar would fall, and stocks most dependent on future earnings, Tesla believes, will be hit hard.

Real inflation fears hurt.

Write to James Mackintosh at [email protected]